A blog about economics, finance, business and corporate governance. My background is in economics, with degrees from Columbia and Johns Hopkins. A career in international development, equity capital markets and as a corporate finance chief and board member lead me to think about events in a different way--hence the blog's name.

Thursday, May 31, 2012

The Wall Street Journal featured this NY Fed chart showing an uptick in student loan delinquencies. There has been much written about millions of homeowners with negative equity "strategically" going delinquent if there were a whiff of an election year bailout. This strategic delinquency phenomenon hasn't occurred, although economists have written that it is economically rational.

I'd offer the theory that students might be different. Students, particularly college students, were said to be a big factor in the last Presidential election, both in terms of organizing, turning out and voting. Students are a pragmatic group, with little ethical baggage and no stakes in preserving a credit rating. They also have a strong sense of entitlement. My tuition's too high. Too much homework. My grades are too low because my professors are lousy. The dorm food's awful. It's not my fault!( remember John Belushi's lament in the "Blues Brothers"?)

If the President were to give college students a pour boire from the Federal trough before the election in some form of loan forgiveness it would probably depend on balances and being in delinquency. Why not get your name on the list now? Behavioral economists--what do you think?

Tuesday, May 29, 2012

I've only seen a limited sample of analyst research on HP, but frankly it's pretty mediocre, especially the financial statement models and the valuation arguments. The equity analysts want to like the stock, for different reasons, but they seem to be struggling to come up with compelling reasons. The equity sales people cry out the familiar mantra, "It's dirt cheap!" So is a wooden nickel.

I've met a few people who work with the company in a variety of functions, and without looking for anything in particular, I hear some consistent sentiments. The prevailing opinion is that former CEO Mark Hurd "gutted" the company with no rhyme or reason, strictly driven by making short-term numbers. He is not held in high regard. On the other hand, CEO Meg Whitman gets high marks for communication inside the company and for taking a measured approach to tough decisions. This, for me, is an important tile in the information mosaic about a company.

However, I continue to be puzzled by the total absence of insider buying. At some point, the CEO needs to say something like this, "Listen team, I've brought you all on board with me to engineer one of the biggest corporate and market turnarounds in history. If you're with me on this, then we all have to have skin in the game. We can't go and peddle this story to institutional buyers if we don't have our own net worths at risk, and I don't mean through options. I mean after-tax cash. The other directors and I are on board with this, and I need each and every one of you to come join us according to your circumstances. Come to me in confidence if you have any questions or concerns." This could be well orchestrated and done in a compliant way fairly easily.

The institutional ownership trends are not very encouraging. Dodge and Cox has clearly put a big stake in the ground through several funds, and the rest of the significant owners are index funds. Some of the other well known value players have chosen other names. I wonder what the value houses are concerned about?

It's a limited data point, but Standard and Poor's research concludes with this paragraph:
"We apply a peer-discount target multiple of 6.0X to our calendar 2012 EPS estimate of $4.16 to arrive at our 12-month target price of $25. This is toward the low end of the seven-year historical range for HPQ, reflecting near-term pressures and our lack of confidence in the company's turnaround prospects." They talk about being in unattractive businesses (PC's and printing) as well as price pressures in the ESSN hardware products. Standard and Poor's sees it as a trade, not as a BUY.

Finally, on the cloud arguments we laid out in the last post, I still believe that if CIO's are going to make big investments in big data and utility (cloud) computing, they will need help in selling the expenditure story to CEOs and support will have to come from the high concept, high science types like Dr. Mike Lynch. Much of the money spent may be mix-and-match projects put together with small and big company offerings which work together. The "one stop shopping" concept for these projects might be a dead letter.

Friday, May 25, 2012

Cloud computing has become the workhorse cliché of tech analysts, CEOs and journalists. Here's a link to a cogent presentation on cloud computing by Ramamurthy and Madurai which helped me to frame my thinking about what this means for tech industry leaders.

I found an analyst report which picked Cisco as the "big winner" in the move to cloud computing. Remember. Cisco's original advertising positioned the company as supplying the "plumbing" for the Internet. Making routers and switches, like plumbing fixtures, should not remain a high margin business as Asian companies start to get global scale. Despite integrating hundreds of acquisitions over the years, the company has settled into a low growth phase, when it has to go out and acquire software companies. Making components and even boxes, like servers, shouldn't attract new shareholders. To its credit, CSCO has been able to maintain margins in its core router and services business, while also generating very healthy service margins. Despite its healthy business and modest valuation why it would be a big winner in cloud computing doesn't follow for me.

I liked this quote which I read as part of an IBM cloud computing discussion: "IT industry must go beyond delivery of components—even integrated components. This environment demands that the IT industry deliver integrated expertise."

In this regard IBM overall looks like it is positioning itself well as a provider of solutions to businesses looking at implementing private cloud computing models in stages. Their offerings feature well designed, integrated systems which I presume are manufactured for them by others. At the heart of their offerings is the image of deep expertise both at the customer level and at the research scientist level. The magic of expert knowledge should enable them to earn a healthy profit on customer implementations, because they are not selling boxes, or blades, or plumbing. Biri Singh seems to be HP's internal cloud computing guru, and hopefully his team will be built out and his portfolio should grow.

An entirely discrete issue is the so called "big data" opportunity. Years ago, the buzz word was "business intelligence," or "BI." Most of those implementations came in late, over budget and didn't provide value. Nobody that I've talked to at some mega-cap user companies can really describe what this might mean for their companies in specific, operational terms. Selling this concept to users will require some magic, and again the magic won't be in boxes, switches, routers, or servers. Autonomy seemed like it was to be the magic that might differentiate HP's offerings in this field in the future.

CEO Whitman made this statement in the conference call: "And we want to transition this to faster-growing, higher-margin sections related to strategic enterprise services. What we consider strategic enterprise services, cloud, security, information management and analytics, and application modernization." Looking at the Autonomy website, this seems to be the portfolio of offerings which it successfully brought to market to top tier customers around the world. Putting HP's Chief Strategy Officer in charge of this business seems like it will make extracting value from this acquisition take longer to realize.

As the CEO stated, the core of HP will be the ESSN business, along with Services and Financing. As this business builds and receives a bigger R and D budget, its revenue and earnings should increase. Offsetting this will be a drag from PSG and a transitioning IPG. It's too early to get excited about this stock unless the price were lower. Can several companies co-exist on The Cloud? Not according to the Rolling Stones:

Thursday, May 24, 2012

The first confusing signal on the second quarter conference call came from the CEO's remarks. She described spending time at Tech Con, an internal HP innovation show which used to have a blog populated by HP Fellows talking about big ideas in the mode of IBM's Watson Research Center. This wasn't a forum about new products, but about big ideas, which seemed to be the point of HP's acquiring Automomy. CEO Whitman was "blown away" by ideas discussed at Tech Con. Upon announcing the expensive acquisition of Autonomy in past quarters, the CEO could then scarcely contain her enthusiasm about the synergy in customer and prospect lists and near-term opportunities. Autonomy was almost not to be found in this quarter, so it would seem as if its offerings were no longer mind blowing. More on this later.

Overall, the quarter looked pretty lackluster, with the reported diluted EPS of $0.81 being below a consensus $0.91, but non-GAAP, diluted EPS of $0.98 coming in above the $0.91, a number whose basis was unknown. It was a positive surprise, and the lifeless analysts on the call were congratulatory about the "execution" in the quarter. I can't find what these analysts were pleased about reading through the financials.

The Enterprise Server, Storage and Networking (ESSN) segment saw revenue decline 5.5% to $5.2 billion, while the segment's pre-tax margin declined 260 basis points to 11.2%. The problem for HP and for the entire industry is that servers and storage have become commodity boxes and services. These items may have to be bundled or serve as loss leaders in a larger, solutions package. CEO Whitman made a strange comment about HP not being penalized as much as larger companies because HP has a $5 billion business in ESSN and not a $30 billion business. This went over my head. Recent newspaper reports have the CEO describing HP's unequaled opportunities in cloud computing. This segment's results are troubling no matter what the spin and don't seem to back up that assertion.

The Services segment reported revenue of $8.8 billion, a decline of 1% year-over-year. Pre-tax margins in this segment declined by 410 basis points to 11.3%. If HP were going to morph into IBM, these kinds of margins won't carry the day for shareholders.

The Imaging Printing Group (IPG) reported a 10.4% decline in revenue to $6.1 billion, with the pre-tax margin dropping by 340 basis points to 13.2%. In a sidebar conversation with an analyst about printer pricing in emerging markets, the CEO said the company was finding that higher printer prices at retail, along with lower supply prices led to better market share and consumer satisfaction. This is just the opposite of the U.S. market strategy, and the pricing of U.S. cartridges and ink has probably peaked out.

The Software segment increased revenue by 21.7% to $970 million, due to the inclusion of Autonomy's revenues for the full quarter. Margins in this segment too fell, by 210 basis points to 17.7%. Autonomy founder and CEO Mike Lynch is leaving the company, which to me doesn't seem to be a good thing and is inconsistent with some of the CEO's remarks about the "big data" opportunity.

Lynch is a Cambridge Ph.D. mathematician who founded Autonomy and got it into FTSE 100 index in London as a global leader in turning mountains of files and data into usable information for decision making and risk management. While he is sometimes equated to Bill Gates, I think that the more appropriate pairing to someone like Steve Wozniak. Selling Autonomy and helping to define the field of big data is something to which Mike Lynch is uniquely suited.

Perhaps HP could have helped him run the business by hiring him a Chief Operating Officer or a smart CFO who would remove all the headaches of running the back office interface to HP and keep the metrics on track. There was a comment about developing a better interface between Autonomy systems and those of HP. Now I know that they really overpaid for Autonomy, but letting Lynch leave seems to make no sense, since the British press suggests he wanted to stay and grow the company he founded in 1996.

The last item for me was the 33% decline in cash from operations to $2.5 billion. This doesn't speak to execution of any kind. Management can produce all the non-GAAP numbers they want, but this is a metric where the rubber meets the road.

Bernstein analyst Toni Sacconaghi suggests that the forward growth rate for HP might be 1%. The company is going to be in a turnaround mode for quite some time, even after having lowered expectations below the level of the roadway. The CEO seems to be trying to convince herself that she can turn this ship around when she makes repeated reference to having been through "a number of these (?) turnarounds." Based on what knowledgeable investors can see forward, it's hard to make a case for the stock, except for appealing to some historical average margins and multiples which are no longer relevant.

The company suggested that there could be a sharp sequential growth in diluted EPS from Q3 to Q4, due to seasonality and to restructuring efforts. Since this is a one-time item, hopefully it is priced in and ignored. I wish I could take a trip to Suffolk and find Dr. Lynch in his favorite pub to talk about "big data."

Wednesday, May 23, 2012

It's curious to me how often I see asset allocation recommendations from brokerage houses suggesting investors increase their exposure to "emerging markets." Let's take the case of India, which seems to have some advantages when compared to fellow BRIC Brazil, which is very sensitive to global commodity prices. India, by contrast, has a burgeoning domestic consumer sector which requires consumer products, retailing and financial services. This provides opportunities for domestic firms because of the restrictions placed on foreign firms looking to expand into Indian markets.

In my mind, a U.S. investor has no reason to look at a significant portfolio exposure to Indian equities, because the potential returns aren't at all commensurate with the risks. The free fall of the Indian rupee leaves it 22% lower against the dollar than a year ago. Indian stock market indexes are down 11% in local currency terms for the three months, and about 18% in U.S.dollar terms according to the Journal.

The Journal says foreign investors put $9 billion into Indian equities in the first three months of 2012, and they are clearly trapped given the illiquidity in equity markets and the currency issues. Morningstar's highest rated fund for Asia ex-Japan is Matthews Pacific Tiger, which has 16% of assets in India, number two behind China in country allocation. However, only one equity, Tata Power, is in the fund's top ten holdings.

Morningstar analyst Patricia Oey says that five year Indian equity market volatility is 39%, measured as a standard deviation, which is higher than the S and P 500. The currency market is probably a much more efficient predictor of future market performance than are the small, inefficient Indian equity exchanges. A U.S. investor could, for the same or lower risk, probably make more money trading in small and micro cap stocks in the U.S., where the investor would have access to managements, Wall Street research, and managements more accustomed to the needs of equity investors.

The Morningstar analyst says, "India also has an unfriendly business environment and widespread corruption." This isn't news, but it's unusual to see it so plainly stated in a research piece. Less well appreciated is the fact that Indian boards and managements are completely tone deaf to their responsibilities towards equity stakeholders, since many large companies are really family companies in public garb.

The central government, which seems to be at sixes and sevens these days about its own agenda has recently gotten into a spat with the Italian government over the trial of Italian sailors accused of murder in India for a crime which may have been committed on an Italian ship in international waters. The Italian envoy has been recalled, and the Italian government has expressed its "strong displeasure" with the Government of India. On the face of it, this may not seem like much to an investor, but it's symptomatic of a central government which seems to take every opportunity it can to make India seem like an erratic, unpredictable, unsophisticated international wannabe rather than an emerging power on the international stage. Investors should get a warning label with their mutual funds: "Investing in India Could Be Bad for Your Wealth."

Tuesday, May 22, 2012

My former graduate school colleague, Paul De Grauwe is currently Professor of Economics at the London School of Economics, and he has written a tome, now in the eight edition, Economics of Monetary Union. I saw him today on Bloomberg video talking about some of the same issues in our last post.

A word he uses quite often in discussing the problems within the European monetary union is "distrust." He applies this term to bond markets. He compares the debt ratios of Spain and the U.K., which he says are broadly similar. Yet, Spanish yields are much higher than U.K. yields, and he notes the difference is that the Spanish sovereign issuer is not in control of the currency in which it issues the debt, namely the euro. In this case, liquidity leaves the Spanish system when markets lose faith, and a liquidity crisis quickly ensues.

He calls for the ECB to become the lender of last resort, to draw a line in the sand and to provide any amount of liquidity to bail the union out of the current crisis, without looking over its shoulder for German support. This is wishful thinking. The ECB is constitutionally directed by its board, over which Germany controls only its own vote. Yet, it will shoulder a disproportionate risk in any such open-ended bailout. So the German interest in this mechanism is what?

Paul does admit in his paper that Greece was probably insolvent at the time it was admitted into the eurozone. Now we start to get to the root of the issues. The EU never hewed to its own published rules and public rhetoric either in admitting new members or in calling them on the carpet for breaking budget or trade deficit guidelines. If the EU has behaved like this for decades, then any practitioner knows that the market comes armed with distrust and its own discipline.

We again reiterate that Spain's problems should all be addressed by cleaning up its own banking system, which would rebuild trust in the credit markets. De Grauwe also makes the point, in another research paper, that Ireland has already undergone a painful "internal devaluation," in which case it might be at the point where it would be better for it to voluntarily leave the euro and grow with an improved relative competitive position. Paul's work is interesting reading.

Today, we know that the young, photogenic Greek leftists were full of bluster but no bite. Instead, they are now going in search of traditional political support for a combination of Euro bonds, debt write downs, and traditional bailouts with "other people's money." Meanwhile, French socialists are behaving no differently from the deposed conservatives in trying to paint Germany in a corner as the obstructionist force to progress. IMF Director Lagarde has joined in on cue, as the WSJ writes the "campaign for join Euro bonds gathers pace." The pace may not be sustained.

No German politician of any stripe, Social Democrat or otherwise, would be able or willing to cede political and economic sovereignty to the extent triggered by issuing a Euro bond instrument. France may be "jousting" with the Germans about Euro bonds, but aside from rhetoric and public relations, the Republic has no leverage.

The BBC did a series of walk around interviews with German citizens about the Euro crisis this morning, and I was amazed at the thoughtfulness of all the answers. Certainly nobody offered a solution. But, I would describe the sentiment as being (1) we wouldn't like the European union/currency/experiment end, but (2) Germany certainly can't be expected to write blank checks or to carry the burden for Greece and others.

There has never been any doubt that a euro zone fracture or breakup would be costly. An economist at the University of Cologne mentioned something that I wasn't aware of: Target 2 funds of the European Central Bank. (I regret not being able to credit his name because it wasn't very audible on my feed) These funds were, in his words, meant to slosh around European central banks to ease short-term liquidity crises without triggering public concerns. He calculates that there are 240 billion euros issued under Target 2, with no clear requirements for repayment. He estimates a Greek exit would wipe out repayment prospects, costing Germany almost thirty percent of this amount, which was its contribution.

Spain's issues are within the purview of a traditional central bank: a real estate bubble. It has already put some of its smaller institutions under central bank control, and it just needs to act quickly and decisively. The sooner it does this, the sooner the rest of Europe can own up to where some of the bad Spanish paper lies.

As some of the German citizens interviewed by the BBC said, it would be a shame if Greece, at 2% of EU GDP could call the day for the end of the euro. The Greeks don't seem ready to march off the cliff today.

Saturday, May 19, 2012

I'm working through Jeffries' most recent Economic Insights published by Ward McCarthy and his group. In it there's a quote from Marchel Alexandrovich, an economist in the International section of Jeffries, which is somewhat tongue in cheek, but nevertheless on the money. In speaking to the Guardian, Alexandrovich says that Greece should be persuaded "and paid to stay in the euro, which would be much cheaper than the alternative." The alternative it seems is more than $500 billion in foreign debt which could at worst be repudiated or more likely written down dramatically.

This is another way of coming at our conclusion about the Greeks having the upper hand at the weekend. On the other hand, just cutting more ECB checks to Greece buys time, but really doesn't resolve the problems. There are lots of very sharp Greek economists on faculties around the world, and it wouldn't surprise me if they weren't being summoned by Greek technocrats to help Athens think through the mechanics and costs of a euro exit. Stay tuned.

Friday, May 18, 2012

Looking back over a tumultuous week, a few things stick out in my notebook.

GREECE
Back in November 2011, we wrote about Greece being able to feasibly exit the euro. We wrote, "The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years." The ECB seems to agree with our exit feasibility thesis today, and the Greek government seems willing to take on the challenge.

I'm not sure I agree with official statements that the ECB would take whatever measures it could to keep Ireland, Spain, and Portugal in the currency union, were Greece to withdraw. Ireland and Spain would be better off outside the euro, and it would have a limited future as an international currency. As this tango continues, the Greeks seem to have the upper hand as we end this week.

COLLEGE TUITIONS
Where have all the Occupy Wall Streeters gone? They've gone to international protests over tuition increases in Quebec, Texas, Berkeley, and London. We've posted about out of control costs at universities, but in the final analysis, it's about value. A U.S. Department of Education site shows that the average net tuition (after grants) at for profit, four year private colleges was about $19,000. Columbia College in the City of New York weighs in at gross tuition of $21,000 before reductions for grants. New York's New School, according to the Department of Education, weighs in at #2 among all private schools, $39.000 in net tuition. Talk about market failure!

The average four year public university comes in at a net tuition of $6,300 per year, with Penn State University being the highest at $14,400 per year. In many of these state institutions, students have to sit through lecture classes with 200 students! No value here: these classes should be free. Beyond the tuition protests, if we spend so much time trying to reform corporate behavior, we should spend more time on our universities trying to instill value creation in them.

HEWLETT PACKARD AND TECH
Disappointing forward guidance from Cisco and markets applauded the announcement of HP's projected headcount reduction of 25-30,000 staffers. HP has been in flux since 2010, and while it's clear that reductions in force had to be taken, the culture inside the company has to be energized, and that is really the most intractable problem for a new leader.

I've coached my daughter's soccer teams since she started in our local Association and through her move into our local Club ("travelling") team. Over the years, I've taken her to see lots of high school, college, and U.S. Women's National team games. I've learned a lot about how girls are different in their approach to the game, both as players and as spectators. The recent shut down of WPS saddens both of us, but it's not surprising, and there's little need for finger pointing or for conspiracy theories.

Our professional sports model is built around a national league, with a broad enough interest to generate major television network coverage. A women's professional soccer league doesn't fit this model, and it may not do so for many years. Changing the scale of operations betwen WUSA and WPA clearly wasn't sufficient, because it didn't address the fundamental problems. Football and baseball were built for this model.

The Women's United Soccer Association (WUSA) began with eight teams in 2001, trying to build on the success of the 1999 American Women's National team. It folded in 2003, despite trying to reduce its cost structure by giving the players a draconian 30% salary cut. WPA began with six teams and more modest expectations, but it too has folded in 2012, despite the marketing momentum of the Women's World Cup in Germany last summer.

I hate to say this, but the women's professional game is pretty boring. Beyond the star power of some of the top players, the overall level of talent is not stellar, and the level of fitness wasn't very good either. Games deteriorated over a forty five minutes into players bunching at both ends with an empty midfield. Defenders hoofed balls at random, bypassing the midfield, to ever slower attackers going one on one with a full back. Even after several decades of a men's professional game in America, the MLS has finally begun to produce a passable professional game, about on a par with the English Championship. The women's professional game has a way to go.

The best games we saw were collegiate games. Even more than the ballyhooed North Carolina women's teams we enjoyed watching the 2006 Santa Clara Broncos who played a continental style game, passing the ball sideways and back maintaining possession while looking for better attacking angles. They were well coached, fit and worked together well. The professional teams seemed to be built on one or two stars per team. This isn't a good formula for success, because soccer is not a game for stars, unlike basketball or ice hockey. Good teams with great teamwork, powered by their leaders, like Japan's Nadeshiko, are what it takes to win at the highest levels.

Girls have lots of sports to choose from, both to play and to watch. Lately, here in the Midwest plains, lacrosse is starting to attract girls away from soccer and other sports. I've noticed that when my daughter goes to watch a soccer game with me, the outing is as much a social event as it is about focusing on a game. Meeting up with friends, going to a common area to chat or to go get food are often more important that focusing on every second of a dull game, which is often why they don't concentrate on it. Girls are social multitaskers at live sporting events.

Our sports eye balls are too divided and jaded for women's soccer and men's soccer, for that matter, to every really flourish. I'd much rather watch Johns Hopkins against Syracuse in men's collegiate lacrosse than to watch American professional soccer of any kind. Men's indoor lacrosse? Boring. Too many sports competing for viewers.

Maybe the answer is for the women's game to be built more on the model of smaller teams in the English Football League One or Two, with heavily local teams, partly owned by fans, and playing in small high school or college stadiums. The problem with this idea is that the game would be competing with a pretty good level of collegiate games.

I know that my daughter and I will be out and about this spring and summer looking for all kinds of girl's and women's soccer games to watch. She will also be playing and doing her refereeing. One day we'll again go to an American women's professional game.

Wednesday, May 16, 2012

The New York Times ran a story about Ohio State University President E. Gordon Gee who is among those university presidents beginning to "confront costs." The story is replete with hand wringing quotes about new business models, unsustainable business models, and doing business in a new way. Don't bet on it. Nothing will change because the vested interests are more resolute than the Taliban, the Federal government fosters profligacy by regulation, consumers (students and their parents) have no leverage, and there is no price competition

Tuition increases at Ohio State historically look like they exceed a CPI-type measure by 2-3% per year. Tuition at OSU has increased 60% since 2002, or about 5% per year. Government appropriations account for about $919 million of a $5 billion budget, about equal to the amount contributed by student fees, some $916 million. Taxpayers and students together contribute about 37% of the budget. Unlike federal and state government funds, which come with all kinds of strings and regulatory hooks, the consumer funds come with accounting for costs in relation to value received.

President E. Gordon Gee's mission over the next five years is to find $1 billion in "inefficient spending" out of the $5 billion budget. This number should be a slam dunk. The Times notes that $75 million can be saved alone by going to a common expense report, which by itself is 7.5% of the reduction goal. I wonder what makes up this number? On the other hand, going to common vendors for copiers, pens(?), and overnight shipping will only save $20 million, which seems too low.

Labor costs are never addressed because the weasel words "inefficient spending" will probably keep them off limits. It looks like Administrative and Professional staff comprise 15,668 FTE out of a 2011 total of 31, 581, or about 50%! Add to this a category called Civil Service staff of 5,116 and together this overhead is 66% of FTE employment. Here's the problem. Tenure track faculty, presumably a primary reason why students pay up to go to OSU, comprise only 9% of employment, or 2,916 FTE.

The payroll appears to be about 38% of the annual budget. Among public universities, OSU is number three in enrollment at 58,867 in all schools. Benefit rates are very high in comparison to the private sector and employees contribute very little to their benefit costs. Benefit rates for the Civil Service class of employees are 45.3% and Unclassified employee rates are 35.1%, both groups being above the faculty rates of 29.6%, which is reduced by the heavy use of adjuncts and non-tenured faculty.

Duplicate departments, programs and centers which do not pull student majors can never be eliminated even by a university President or Trustees without a full scale war with the faculty.

The Times articles talks about an "arms race" for buildings and student amenities, but these are what consumers want and have to live with, after all. Donors who often fund these buildings do try to build in some revenue opportunities. There's no doubt that some universities go overboard, but this isn't as big a problem as what Andrew Rosen, CEO of Kaplan, Inc., calls "Harvard envy." This phenomenon is about creating new vanity programs and curricula to enhance the academic status of schools like OSU.

In this election year, the Federal government and Congress will look to throw a bone to students with outstanding loan balances, which is very unfortunate, because these amounts are a manifestation of the underlying problem, which is in academia itself.

Zac Bissonette wrote a book which all parents of college age kids should read and give to their children, called "Debt Free U." Put together with Rosen's more strategic volume, it will give you a much better picture than the puff piece in the New York Times.

Monday, May 14, 2012

Scanning the headlines today, I reflected again on Simon Derrick's presentation in Minneapolis last week. He did suggest that "weasel words" would increasingly populate official statements from European prime ministers and Euroland officials. The Bundesbank's Chief Economist started the trend, when the WSJ reported "...days after the Bundesbank's chief economist, in testimony to the German Parliament, said German inflation could be higher than the euro-zone average for a time if the country takes steps to boost its service sector and raise investment while Greece and others slash wages and government spending."

The Bundesbank's President Jens Weidmann quickly blustered about the bank's resolve in fighting inflation, but at the same time he alluded to a word, "rebalancing," which seemed to allow the possibility of higher EU inflation rates if the periphery countries made adjustments. From this, other stories appeared about Chancellor Merkel's being willing to accept the fact that the ECB would have to lead a European triage effort by printing trillions of Euros.

None of this seems at all probable. The German electorate is already beginning to turn against the ruling coalition led by Chancellor Merkel. German banks and businesses, particularly the exporters, would not be happy thinking about the electoral alternatives to the current coalition.

For over two years, we've explained why we think that the euro was doomed in its current construction. A weak zone and strong zone European union would be inefficient, ineffective and politically unpalatable all around. We mentioned Simon Derrick's comment about adopting the euro devastated the economies of Ireland, Spain and other peripheral members. He also mentioned a true tail risk, something which on the face of it seems impossible. What if Germany left the euro?

German interests are not served by any of the possibilities currently being discussed, so the more likely solution is that Chancellor Merkel picks the least repugnant, sub-optimal choice from a bad menu. However, leaving the euro itself and letting everyone else sort it out is worth thinking through.

Incidentally, as bad as the prospective returns are for U.S. Treasuries, they may again serve as short-term haven for European assets as they continue to flow out of European banks and investments looking for a better home.

A post which has had a long, steady readership is one relating to AIG's risk management czar. It relates very closely to the latest kerfuffle at JP MorganChase.

The whole notion that the JPM unit was hedging its dealer bond portfolio is implausible. For the sake of argument, let's say that is what Bruno Iksil was doing. Since he was using the abstruse synthetic index, then he would have had some sort of hedge ratio and not have been hedging dollar for dollar. The size of his bets are implausible for a hedge. If this wasn't proprietary trading, then we'll never be able to define it, which is why the whole Dodd-Frank regulatory wordsmithing is a waste of time.

The next thought is that Iksil's trading strategy itself was naive and incompetent. He ventured into what had been a relatively obscure part of the fixed income market place, which is where one might go to find and exploit market inefficiencies. Except, once the size of his book ballooned, the relatively small club which populates this corner of the casino knew something was up and the name "London Whale" was born. As one market participant said, Iskil had committed a fatal error, in an inefficient market, he had "become the market."

What happened next seems unclear in journalists accounts. Someone at JPM said to reverse the trades. Now the real problems began, because the same JPM brokers who had called hedge funds and others about his initial position now made called the same market players about the opposite position in size. That could only mean one thing: the whale had been harpooned. Now it was a freebie opportunity for playing the other side.

Inside JPM, no internal controls or proprietary risk management systems had prevented this position from becoming so out sized. The bank can claim that they were always in touch with the New York Fed, and that they jointly decided to take action. One small thing: someone forgot to let the outspoken CEO know about it. His chagrin is palpable in every photograph. It's impossible for any CEO to have his hands this close to a business whose risk profile changes by the hours.

Iksil's boss, who made $14 million last year will fall on her sword and move to a hedge fund. Nothing in the yet to be minted regulations will ever break this vicious cycle of big bets, big wins, big compensation, big bust, and move to the next casino.

Financial innovation is not doing anything to lift the world economy out of the global slowdown. Then, why is this such a valuable, highly compensated function? As imperfect as the Volcker Rule is, if it leads to the bifurcation of commercial banking and investment banking, with its proprietary trading that's progress. Regulation, ERM, and better board governance are pie in the sky, delusional thinking.

If we really and truly want less systemic risk, then normal commercial banking has to become much more like a utility, and investment banking has to find a way to operate without implicit guarantees which will always produce risk seeking behavior.

Thursday, May 10, 2012

The CFA Society of Minnesota hosted Samarjit Shankar and Simon Derrick of BNY Mellon. Shankar's presentation covered their iFlows product for traders which tracks $33 trillion in daily institutional trading volumes, which he said is about 15-27% of overall volume. These represent real transactions and real positions submitted by their clients, which are aggregated, parsed and returned in reports before the opening bell the following day. It's about as close to real time flows as is feasible.

Simon Derrick is the head of the Currency Strategy team at BNY Mellon. It was an interesting presentation, very much in line with what we've been saying since the beginning of the Euro crisis, but Derrick's presentation incorporates current iFlow data analysis and forecasts.

Non-European investors have not pulled away from the euro, which is still key to their diversification away from the dollar. Rather they have reallocated their purchases away from the periphery--Spain, Portugal and Poland--towards the core countries. Current instruments of safety are bunds, U.S. Treasuries, and Swiss bonds. The Australian dollar, charts showed, is heavily leveraged to the Chinese currency.

Derrick noted the same design flaws in the currency union that we have noted. His overall characterization of the euro, abstracting from any allegiance to the British position, is that it has been "a disaster." That got some heads raised from picking at their salads.

In his view, a euro built on Germany, the Benelux countries, and Norway could have been a strong, viable currency even without fiscal unification. Notice the omission of France from his list. The admission of Italy, nominally the third largest European economy, was the beginning of cracks in the system. After this admission, he says, it was politically impossible not to open up the doors of the euro to all comers.

China's reserve currency stockpile has been and continues to be a major factor in the Eurozone and in the valuation of the euro: a distinction which Derrick feels is key. In 2005, BNY data shows that China's official reserves were 75% in U.S. dollars, whereas the level fell to 57% as of the end of last summer. The diversification between these two periods was primarily to the euro, which kept the official euro exchange rate strong.

In fact, he says, it has been changes in Chinese reserve growth that have statistically best explained runups or flattening in the euro exchange rate. This diversification and its impact on the euro rate are quite unrelated to current developments in the Eurozone circus of meetings, and conferences and resolutions. I thought this was a very helpful insight, as it has been difficult for me to understand why the euro rate seems to hang at relatively high levels.

Their forecast for the back half of 2012 is not fun. Weakening oil prices, which we've always felt were not driven by fundamentals anyway. Slowing Chinese growth, which means zero growth in Chinese official reserves. This means that the major pillar of support for the euro exchange rate will start eroding towards the end of the year.

European populations are totally out of sync with their elected leadership who talk about austerity. Thus, as we have long said, it is political suicide for governments to continue to support austerity imposed by outside nations in the Eurozone. Derrick saw a scenario where "weasal words" would be used to walk away from the austerity concepts. Classic diplomacy.

An important announcement had been made by the China Investment Corporation that it would not add any further to its purchases of European sovereign debt. Since the CIC had already been moving away from peripheral debt, this isn't good news for the core countries. Derrick foresees a "quantitative easing" for Europe which will ultimately serve to put the euro in further peril. He didn't elaborate on what this meant, but he didn't seem to be talking about the hull of the ship splitting in two, but perhaps a slow descent to the ocean floor.

I asked Simon about recent comments about creating a "soft Eurozone," and a "hard Eurozone." He dismissed these as inoperable and wishful thinking.

A tail risk, he said, was that Greece leaves the euro and re-establishes the drachma. One of the factors which makes this not too difficult is the fact that very little Greek debt is held by external creditors, so that there would not be protracted negotiations about revaluations. Capital, he said, has already flown, so that is not a big issue either.

This led to a very interesting discussion with the Mancunian Simon who graduated from University College, London, where he lives. London property values are at record levels, which is not the case in other areas like the Midlands. Why? French investors are now looking for safety in real assets, and London property is a ferry boat ride or puddle jumper away. He talked about the London football clubs, like Chelsea, Arsenal and QPR, as being safe, real assets which are fun to own! I wonder if this means a French consortium bid for Spurs?

In the tail risk case where Greece were to leave the euro is a somewhat orderly way, Derrick feared the domino effect which would result in Ireland, Spain and Portugal leaving also. At the same time, he said, the current euro system had "devastated" those economies in terms of resource misallocation, so leaving might be the best long-term strategy.

I couldn't finish my salad, but this presentation was definitely food for thought.

Wednesday, May 9, 2012

"Talk about March Madness: consumers went on a borrowing spree, adding $21.4 billion in borrowing for the month.The surge was the largest–in both dollar and percentage terms–since November 2001. What was unusual was an increase of $5.2 billion in revolving debt. The category–which includes credit cards–had been on a downtrend over the last three years. That lack of credit use had limited consumer spending."

I don't see how this is a good thing. The people with strong credit ratings and FICO scores continue to use their point cards, but pay off the balances. Card issuers have purged weaker credits from their files, as well as lowering their limits, increasing fees and margins, and tightening up grace periods for the average consumer, meaning everyone but lawyers, venture capitalists, politicians, and hedge fund managers. If the average consumer is using this unsecured credit to ramp up spending, which may very well be likely, it won't turn out to be a "good thing." It could be that consumers are buying Vespas.

Tuesday, May 8, 2012

Dodge and Cox Growth Fund's portfolio managers Diana Strandberg and Charles Pohl recently gave an interview to Morningstar in which they made a brief, clear case for their thinking in adding the much maligned Nokia to the portfolio. It's the value investor's case in a nutshell, and one very much in tune with my analyst practice on both the buy and sell sides. Strandberg and Pohl appear on the featured video for 5/8/2012 on the Morningstar subscription site.

On research with no value, we have the comment from a Wedbush Morgan analyst that Select Comfort is a "Buy" at $30 with a $39 target price. The company, to its credit, has branded the air mattress. Remember the one that many of us purchased at the army & navy store for $10? A marketing person came up with a dial on an electric pump, branded it your "Sleep Number" and sold a story of restful nights counting sheep for a premium mattress investment. Sales took off and profits followed. However, when the shares hit $1 during the financial crisis, with the same business, same pricing and same marketing strategy, analysts were in their bunkers, reducing any positive ratings to "Hold." This is exactly when savvy analysts and investors do their work and Buy. Today, hedge fund mogul Steven Cohen has been accumulating shares at average prices of $29. Tomorrow, we might expect "Strong Buys."

I don't know if Dodge & Cox are right on Nokia. I went the wrong way on it early in its evolution, but certainly their risk/reward proposition makes more sense than taking a flyer on air mattresses.

Instead of pulling out of Afghanistan, Karzai has successfully played the Obama administration, which is totally focused on re-election, into a preposterous security deal which perpetuates his regime and lines his pockets with U.S. taxpayer money.

In the months leading up to this desperate deal, we had to listen to President Karzai demand the end to drone flights, allowing prosecution of U.S. military personnel in Afghan courts for crimes against civilians, and prior notice of military actions against Taliban targets. It was a well laid out plan which took the PR initiative and put the U.S. on the defensive. Karzai understood his Presidential counterpart's re-election needs all too well. Now, billions more in taxpayer dollars will flow to a regime of a failed state which no amount of foreign nation building can resuscitate. Meanwhile, there is no agenda for Pakistan, without which there can be no long run solution for Afghanistan anyway.

"The Taliban and criminal gangs, old and new warlords, and tribal leaders rule vast parts of the country. The authority of the government, many of whose ministers are considered corrupt, barely extends beyond its offices in Kabul. In order to survive, the Karzai government has to ignore or accommodate all those forces working to undermine it, from the Taliban to the warlords. This has even empowered them, occasionally forcing Karzai to appoint them as governors or to acknowledge their local authority.

Based on these criteria, Afghanistan is a failed state. For years, it has been, and still is, one of the world's top 10 failed states, along with Sudan, Somalia, Iraq, Zimbabwe, and others.In an effort to secure his government's survival, Karzai invited "non terrorist Taliban" to participate in the government. He even proposed negotiations to Taliban leader Mullah Omar, saying he would guarantee Omar's safety if he would accept the authority of the government. Omar's group rejected that proposal, saying that it is Karzai himself, and not the Taliban leader, who should be concerned about his safety.

Longing for security and an improvement in their lives, Afghans have been increasingly turning their backs on a government that has failed to deliver either. A recent ABC/BBC/ARD poll indicated that support among Afghans for the Karzai government and U.S. efforts has dropped by half since 2005. The biggest danger is that, as in 1996 after four years of chaotic mujahedin rule, people will have no choice but to turn to the Taliban to impose countrywide "security" within the framework of an archaic and totally repressive system.

Reports that Karzai's brother Ahmad Wali, head of the Kandahar Provincial Council, has been involved in drug trafficking have caused widespread public disappointment. A second Karzai brother has taken over Afghanistan's only concrete factory in Pul-i Khumri and acquired by dubious means ownership rights to vast state lands. A third brother, Jalil Karzai, is said to have simply driven away after a recent car crash in Kabul involving his car and a taxi that killed five people.

Escalating violence and widespread corruption fueled a surge in opium poppy cultivation in 2006 and 2007, pushing opium output to an all-time high. Despite efforts by the Afghan government and their U.S.partners, Afghanistan is now the source of more than 90 percent of the world's illegal opium."

The writers of this story strive to be optimistic, saying that forty percent of the population believe that the country is moving in the "right direction." The math isn't complicated: sixty percent of the population do not believe it.

There's no doubt that we have to stay engaged with the Afghan people, but a military vanguard with no winnable mission isn't the answer. Funding a cynical, self-serving government that is beholden to militant extremists like the Haqqani Network for survival, is not the answer either.

Monday, May 7, 2012

As we've noted in a previous post, the Yale Endowment has taken a very aggressive position in using alternative investments in its portfolio's asset allocation. For the year ended June 30, 2011, alternative investments in total (absolute return hedge funds, private equity, and real assets comprised 81.5% of the portfolio! Liquid investments (domestic equity, foreign equity, and fixed income) net of cash comprised 18.5% of the portfolio.

This statement appears in the annual report, "...the actual (2011) allocation produces a portfolio expected to grow at 6.3% (real) with a risk of 15.4%. Disclosures in the report don't provide expected returns by asset class, nor do they suggest the distribution of expected portfolio returns for which 6.3% might be a measure of central tendency. I confess to being surprised that the portfolio's expected real rate of return was not higher given the preponderance of alternative assets.

This, in turn, made me start thinking about other studies of expected return and about the gross distortions being introduced into financial markets by the Fed's enabling policy of spreading liquidity around like Halloween candy.

Vanguard's Capital Markets Model recently ran simulations on the expected average annualized returns for a 50/50 equity-bond portfolio. Their results returned a nominal portfolio return centered in the range of 4.5%-6.5%, or in real terms an expected range of 3.5%-4.5% over the next decade. These are pretty meager returns for most investors, especially when compared to historical returns over the Great Moderation.

So, the Yale Endowment portfolio is expected to outperform the Vanguard investor's simulated, balanced portfolio by 180-280 basis points over the investment horizon.

Reading the Endowment's report for the period ended June 30, 2011 doesn't clear up some of the obvious questions. Performance numbers are given in nominal terms. Yale's domestic equity portfolio returned 24.5% for the year, underperforming their benchmark index return, as opposed to the expected return, by 7.8%. The foreign equity portfolio by contrast returned 18.6%, outperforming its benchmark index return 7.0%.

The absolute return hedge fund asset class, 17.5% of the portfolio, returned 12.7% for the year. From previous annual reports, one can read that this class is expected to return 12-13% per annum, and so this was right in line with expected returns. Historically, absolute return funds as a class have produced a 10.2% annual return, so Yale's 2011 performance was better than the long-term historical average performance of the asset class. Given Yale's' assumption about correlations between absolute return and liquid equities being zero, and the variance of absolute return being about one-third that of equities, absolute return funds lowered the overall portfolio variance as well as raising its returns. Almost a free lunch!

So, in this persistent, distorted low rate environment, ordinary investors are forced to chase yield and return. If investors are seeking to lower risk, they don't have the options that the Yale Endowment does, rather they have to fly to Treasuries and bid up their prices to the point where their risk may increase rather than decrease. Talk about distorted market signals!

Liquid investments, like domestic public equities, generally offer lower returns because this liquidity comes at a premium. However, in the low rate environment against a risky economic background, investors tend to pay too much for this liquidity, thereby depressing the likelihood of higher future returns. Again, market prices are distorted from long-term, economic cash flow related valuations.

Finally, corporations flush with cash focus on stock buybacks and dividend increases rather than on productive investments for the future, which don't offer the easy returns fostered by this low rate environment. Berkshire Hathaway analysts have suggested that instead of more cash flow reallocation to insurance businesses within the portfolio, investments like Burlington Northern Santa Fe should be keeping their cash flows and making long-term investments to grow and maintain their economic moat in the future. However, the promise of almost eternal low rates pushes even astute managers to take the easy road to short term gains.

Thursday, May 3, 2012

My previous post about alternative investments and the Yale experience drew considerable readership and a few questions. In various talks, Dave Swensen has characterized alternative investments, e.g. real estate, commodities, and private equity, as offering higher returns in order to compensate investors for risk and for their illiquidity. This makes them perfect vehicles for investors like the Yale Endowment which, as Swensen says, is built to be indefinitely lived and which should not have liquidity needs.

In the previous post, we noted that the liquid part of the endowment offers a substantial cushion even in the unlikely event that the fund were to have liquidity needs. So, an investor like the Yale Endowment is perfectly suited to maximize alternative investments in particularly illiquid vehicles like private equity. To the extent that Yale has a long history with private equity fund managers, who in turn are attracted to Yale's size and appetite, Yale should be able to enjoy a higher return and lower risk profile for its alternative investments than other institutional investors.

Now, take the case of institutional investors like state pension funds. As we noted before, they neither have the experience, competence or appetite for risk that the Yale Endowment does. And, most importantly, state retirement funds may very well face liquidity issues in the future. A significant body of academic research shows that the unfunded pension liability of state funds in Ohio, Illinois and Texas for example, will ultimately require large tax increases to pay for the tails in actuarial lives of current retirees as well as for future retirees.What if the taxpayers revolt? What if these funds somewhere down the road are restructured into two-part vehicles combining a DB element with a DC element? I'm not saying that this will happen, simply because of our politics. However, unlikely doesn't mean improbable. Political forecasters do worse than economic forecasters, after all. As Dana Carvey's George H.W. Bush would say, "Gotta be prudent!"

State pension funds cannot afford to reach for return in the way the Yale Endowment does. Finally, the last group which is completely ill-suited for alternative investments is the average individual investor, who could easily be subject to unexpected events like a catastrophic, uninsured illness or unplanned for long-term care.

In what seemed to my readers to be a contradiction, Dave Swensen has advocated portfolio construction for individual investors from traditional asset classes, using low-cost index funds. Alternative investments are a no-no for these investors, he says. In fact, it's not a contradiction at all.

Yesterday, the University of St. Thomas hosted Archbishop Francis Chullikatt, who is the Papal Nuncio and Permanent Observer of the Holy See to the United Nations, speaking on the subject of religious liberty. In my time working at the United Nations, some Papal Nuncios chose to do their work behind the scenes, like good diplomats, and they were not often outspoken. Archbishop Chullikatt's international experience as a diplomat and pastor, recently in Iraq, demands that he be outspoken on issues which he has experienced personally. The auditorium's full house was in rapt attention during his remarks.

In 1987, he said that there were 1.4 million Chaldean Christians living in Iraq. In northern Mosul, across the river from Nineveh, Chaldean Christians had long been the majority in the city. In 2010, the Syriac Catholic Cathedral was attacked by gunmen, killing 52 men, women and children. Children, he said, were shot in open view of their mothers before they themselves were killed. Two priests, both personally known to Archbishop Chullikatt, were also killed.

By 2003, only 800,000 Christians remained in Iraq, and today the number is about 200,000. A large community of Iraqi Christians has established itself in Detroit. In May 2011, St. Mina Coptic Church was burned to the ground in Egypt while the Egyptian army stood passively and watched. Incredibly, the Grand Mufti of Saudi Arabia, the highest religious authority in the country, called for the destruction of all Christian churches on the Arabian Peninsula. Western mainstream media stories reacting against these inflammatory remarks are curiously absent from Google searches on the subject.

The Papal Nuncio cites persecution of Christians in Nigeria, India, Pakistan and Burma. In Burma, he notes, Christians are portayed as carriers of Western liberalism and lax cultural mores, such as women's rights. Burmese nationalists, who clothe themselves in Buddhist trappings without the values, focus their efforts on the Christians are representing unwanted outsiders who are enemies of the true Burma.

In our own country, Archbishop Chullikatt cited the philosopher Christopher Dawson, who said that the modern state is no longer satisfied with the "passive obedience" of the governed, but it increasingly requires its ambit to stretch out over every aspect of the lives of its citizens from cradle to the grave. Thus, our own government's constant reference to "worship" (as opposed to religion) as being a private matter.

For a much better reflection of the Nuncio's views, here is a link to his talk at the April National Prayer Breakfast. I am really glad to have had the opportunity to hear such an impassioned and informative talk on a subject of vital worldwide importance.